[copy also posted to LinkedIn]
Got something in my e-mail inbox the other day from Crescendo Interactive inviting me to propose a paper for the 2021 iteration of their "practical planned giving conference," which they are hoping to do live in Orlando next September. The 2020 conference is already up and running virtually, and the sessions this year are free. You might want to check it out.
Much of the programming is focused on fundraising and stewardship, but there is room for the occasional foray into tax tech, so I went ahead and pitched an idea for a talk at next year's conference. Here is the pitch:
Outside the Box: the Nonqualified Lead Trust
With 7520 rates at historic lows, the charitable lead annuity trust can yield a steep discount on the remainder gift to noncharitable beneficiaries. If we are funding the trust with closely held stock, it may not be possible to meet the 60 pct. exception to the prohibition against excess business holdings. But there is a workaround. If the lead interest does not qualify for a gift tax charitable deduction, and if we render the gift of the income interest incomplete, we can still discount the remainder gift while avoiding the private foundation excise tax regime altogether. Let's take an hour or so to examine the nonqualified lead trust.
Okay, well, they allowed only one paragraph. I had to pack a lot into a small space. At slightly greater length, the pitch might have looked more like this:
Most of us are aware that a split-interest trust that is holding amounts for which an income or gift tax charitable deduction has been allowed is to that extent subject to the private foundation excise tax regime. And many of us are aware that there is an exception to the prohibition against excess business holdings in the case of a charitable lead annuity trust, where the present value of the unexpired annuity stream is not more than 60 pct. of the value of the trust corpus. If we are trying to leverage the present value of a remainder gift to noncharitable beneficiaries, we are unlikely to meet that exception, at least at the front end.
But what if, thinking outside the box, we were to not claim the gift tax charitable deduction? Or what if we structured the payout as something other than a fixed annuity or unitrust, so that it would not qualify?
We could still discount the remainder gift by the present value of the "income" stream, and by reserving a power to direct the payout to charities we could render the "income" gift incomplete.
And so on.
Obviously these ideas are not original with me, but they are not discussed all that often, and as a result these strategies may be underutilized where they could do some good.
I did touch on the nonqualified lead trust briefly in the closing slides of the lead trust session of a series of narrated slide decks I recently completed -- what they call "asynchronous webinars" in continuing education speak -- comprising a complete, somewhat advanced course on tax-advantaged charitable gift planning techniques.
These are gathered under the collective title "PG 103: stuff every gift planner should kinda know" and posted to a storefront tab on this site. I am in conversation with CFRE International to get these cleared for continuing education credit for their certificate holders.
But let us take a minute to expand on the idea of the nonqualified lead trust. If my paper is accepted I am going to have to work all this up before next September anyway, so let's start taking notes.
in broad strokes
The object is to try to replicate some of the income and transfer tax benefits of a qualified nongrantor lead trust without triggering an excise tax on excess business holdings. At least some discount on the value of the remainder gift, in other words, but somehow avoiding application of section 4947(a)(2) by not holding amounts for which an income or gift tax charitable deduction has been allowed.
Maybe without having to meet a fixed annuity payout, which might have to be paired with staged redemptions, or maybe by borrowing from an "intentionally defective grantor trust" to meet the payout obligation, which would be self-dealing if the private foundation excise tax rules applied. We can work out those details later. What we are looking for here is the flexibility to make those decisions.
Code section 2522(c)(2) disallows a gift tax charitable deduction for a contribution to a lead trust unless the payout is in the form of a fixed annuity or a unitrust amount. So if we set up a lead trust instead paying, say, net fiduciary accounting income, the lead interest would not qualify.
The remainder gift would still be discounted, albeit not by nearly as much. In a low interest rate environment, a fixed annuity provides very strong leverage, a net income payout almost worse than none. Remainder values after a term unitrust are not affected by fluctuations in the 7520 rate.
getting into the weeds
Or perhaps we should hedge even this claim by saying the income interest to charity "should not" be treated, for purposes of section 2702, as having been "retained" by the settlor, within the meaning of reg. section 25.2702-2(a)(3). The remainder gift "should" be discounted, in other words, though we have no formal or informal guidance from IRS on the question.
But while we are forgoing the gift tax charitable deduction, we do not want to "waste" lifetime exclusion -- or worse, pay gift tax out of pocket -- on amounts that are in fact going to charity. So we would want to render the gift of the income interest incomplete, per reg. section 25.2511-2(c), until distributions are actually made, by reserving to the settlor a power to allocate among charitable distributees. Per section 674(b)(4), this would not trigger "grantor" trust treatment.
IRS did actually confirm this analysis in PLR 9742006. In the particular case, the settlor had also retained a testamentary power to alter the disposition to or among the remainder beneficiaries, rendering the entire gift incomplete.
More formally, in Rev. Rul. 77-275, IRS ruled that a settlor's reserved power to allocate income among charitable distributees would render the gift incomplete. The ruling did not expressly address the 674(b)(4) question, but since this was a pre-1988 "Clifford" trust, with a term of ten years and one month, the inference would be that this was not a "grantor" trust.
However, the reserved power would cause inclusion in the settlor's estate per section 2038(a), with no offset for the unexpired, nonqualified term. So, as in the case of a grantor retained annuity trust, it would be important to set the term well within the settlor's life expectancy. And to be prepared to accept the consequences of an early death.
As with any nongrantor lead trust, the nonqualified trust would be taxed as a "complex" trust, with an income tax deduction per section 642(c)(1) exactly offsetting current net fiduciary accounting income, potentially including any realized gains.
Although reg. section 1.642(c)-3(b)(2) requires that the charitable deduction be pro rated across various classes of income, thereby defeating any "ordering rule" that might otherwise purport to distribute items subject to higher rates first, reg. section 1.642(c)-3(c) does allow a deduction for distribution of realized gains, if the trust instrument includes these in the mix. So let's do at least that.
And then, if we are funding the trust with interests in a passthrough entity, we will have to deal with the fact that the income tax charitable deduction will be limited to the extent we are funding distributions with unrelated business taxable income.
the takeaway
If we are not claiming a gift tax charitable deduction, and if the only amounts for which income tax deductions have been allowed are no longer being held by the trust, we should not be subject to the private foundation excise tax regime. We need not concern ourselves with excess business holdings or with the prohibition on acts of self-dealing, notably including borrowing from or lending to the trust.
IRS has ruled privately to this effect twice. PLRs 201713002 and 201713003, identical verbatim, concerned a charitable remainder unitrust. PLR 200714025 concerned an ordinary "complex" trust in which the trustee had discretion to make deductible distributions to charity. In both instances, IRS agreed section 4947(a)(2) did not apply.
This is where we make the obligatory note that a letter ruling is not precedent, but applies only to the taxpayer who requested it.
Anyway, those are the broad outlines of the material I will be pulling together for the Crescendo conference. Regardless whether my proposal is accepted, I will be shaping this into a one-hour webinar, which will end up alongside the others on the storefront tab on this site.
Got something in my e-mail inbox the other day from Crescendo Interactive inviting me to propose a paper for the 2021 iteration of their "practical planned giving conference," which they are hoping to do live in Orlando next September. The 2020 conference is already up and running virtually, and the sessions this year are free. You might want to check it out.
Much of the programming is focused on fundraising and stewardship, but there is room for the occasional foray into tax tech, so I went ahead and pitched an idea for a talk at next year's conference. Here is the pitch:
Outside the Box: the Nonqualified Lead Trust
With 7520 rates at historic lows, the charitable lead annuity trust can yield a steep discount on the remainder gift to noncharitable beneficiaries. If we are funding the trust with closely held stock, it may not be possible to meet the 60 pct. exception to the prohibition against excess business holdings. But there is a workaround. If the lead interest does not qualify for a gift tax charitable deduction, and if we render the gift of the income interest incomplete, we can still discount the remainder gift while avoiding the private foundation excise tax regime altogether. Let's take an hour or so to examine the nonqualified lead trust.
Okay, well, they allowed only one paragraph. I had to pack a lot into a small space. At slightly greater length, the pitch might have looked more like this:
Most of us are aware that a split-interest trust that is holding amounts for which an income or gift tax charitable deduction has been allowed is to that extent subject to the private foundation excise tax regime. And many of us are aware that there is an exception to the prohibition against excess business holdings in the case of a charitable lead annuity trust, where the present value of the unexpired annuity stream is not more than 60 pct. of the value of the trust corpus. If we are trying to leverage the present value of a remainder gift to noncharitable beneficiaries, we are unlikely to meet that exception, at least at the front end.
But what if, thinking outside the box, we were to not claim the gift tax charitable deduction? Or what if we structured the payout as something other than a fixed annuity or unitrust, so that it would not qualify?
We could still discount the remainder gift by the present value of the "income" stream, and by reserving a power to direct the payout to charities we could render the "income" gift incomplete.
And so on.
Obviously these ideas are not original with me, but they are not discussed all that often, and as a result these strategies may be underutilized where they could do some good.
I did touch on the nonqualified lead trust briefly in the closing slides of the lead trust session of a series of narrated slide decks I recently completed -- what they call "asynchronous webinars" in continuing education speak -- comprising a complete, somewhat advanced course on tax-advantaged charitable gift planning techniques.
These are gathered under the collective title "PG 103: stuff every gift planner should kinda know" and posted to a storefront tab on this site. I am in conversation with CFRE International to get these cleared for continuing education credit for their certificate holders.
But let us take a minute to expand on the idea of the nonqualified lead trust. If my paper is accepted I am going to have to work all this up before next September anyway, so let's start taking notes.
in broad strokes
The object is to try to replicate some of the income and transfer tax benefits of a qualified nongrantor lead trust without triggering an excise tax on excess business holdings. At least some discount on the value of the remainder gift, in other words, but somehow avoiding application of section 4947(a)(2) by not holding amounts for which an income or gift tax charitable deduction has been allowed.
Maybe without having to meet a fixed annuity payout, which might have to be paired with staged redemptions, or maybe by borrowing from an "intentionally defective grantor trust" to meet the payout obligation, which would be self-dealing if the private foundation excise tax rules applied. We can work out those details later. What we are looking for here is the flexibility to make those decisions.
Code section 2522(c)(2) disallows a gift tax charitable deduction for a contribution to a lead trust unless the payout is in the form of a fixed annuity or a unitrust amount. So if we set up a lead trust instead paying, say, net fiduciary accounting income, the lead interest would not qualify.
The remainder gift would still be discounted, albeit not by nearly as much. In a low interest rate environment, a fixed annuity provides very strong leverage, a net income payout almost worse than none. Remainder values after a term unitrust are not affected by fluctuations in the 7520 rate.
getting into the weeds
Or perhaps we should hedge even this claim by saying the income interest to charity "should not" be treated, for purposes of section 2702, as having been "retained" by the settlor, within the meaning of reg. section 25.2702-2(a)(3). The remainder gift "should" be discounted, in other words, though we have no formal or informal guidance from IRS on the question.
But while we are forgoing the gift tax charitable deduction, we do not want to "waste" lifetime exclusion -- or worse, pay gift tax out of pocket -- on amounts that are in fact going to charity. So we would want to render the gift of the income interest incomplete, per reg. section 25.2511-2(c), until distributions are actually made, by reserving to the settlor a power to allocate among charitable distributees. Per section 674(b)(4), this would not trigger "grantor" trust treatment.
IRS did actually confirm this analysis in PLR 9742006. In the particular case, the settlor had also retained a testamentary power to alter the disposition to or among the remainder beneficiaries, rendering the entire gift incomplete.
More formally, in Rev. Rul. 77-275, IRS ruled that a settlor's reserved power to allocate income among charitable distributees would render the gift incomplete. The ruling did not expressly address the 674(b)(4) question, but since this was a pre-1988 "Clifford" trust, with a term of ten years and one month, the inference would be that this was not a "grantor" trust.
However, the reserved power would cause inclusion in the settlor's estate per section 2038(a), with no offset for the unexpired, nonqualified term. So, as in the case of a grantor retained annuity trust, it would be important to set the term well within the settlor's life expectancy. And to be prepared to accept the consequences of an early death.
As with any nongrantor lead trust, the nonqualified trust would be taxed as a "complex" trust, with an income tax deduction per section 642(c)(1) exactly offsetting current net fiduciary accounting income, potentially including any realized gains.
Although reg. section 1.642(c)-3(b)(2) requires that the charitable deduction be pro rated across various classes of income, thereby defeating any "ordering rule" that might otherwise purport to distribute items subject to higher rates first, reg. section 1.642(c)-3(c) does allow a deduction for distribution of realized gains, if the trust instrument includes these in the mix. So let's do at least that.
And then, if we are funding the trust with interests in a passthrough entity, we will have to deal with the fact that the income tax charitable deduction will be limited to the extent we are funding distributions with unrelated business taxable income.
the takeaway
If we are not claiming a gift tax charitable deduction, and if the only amounts for which income tax deductions have been allowed are no longer being held by the trust, we should not be subject to the private foundation excise tax regime. We need not concern ourselves with excess business holdings or with the prohibition on acts of self-dealing, notably including borrowing from or lending to the trust.
IRS has ruled privately to this effect twice. PLRs 201713002 and 201713003, identical verbatim, concerned a charitable remainder unitrust. PLR 200714025 concerned an ordinary "complex" trust in which the trustee had discretion to make deductible distributions to charity. In both instances, IRS agreed section 4947(a)(2) did not apply.
This is where we make the obligatory note that a letter ruling is not precedent, but applies only to the taxpayer who requested it.
Anyway, those are the broad outlines of the material I will be pulling together for the Crescendo conference. Regardless whether my proposal is accepted, I will be shaping this into a one-hour webinar, which will end up alongside the others on the storefront tab on this site.
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