Payment Method

Bifurcating the interests of a charitable trust between two types of beneficiaries (one charitable; the other private) creates a problem in determining the present value of each part. To prevent manipulation of these values to create a higher charitable deduction, the Internal Revenue Service (“IRS”) imposes certain restrictions on the use of split interest trusts to ensure that the amount ultimately received by the charity corresponds to the amount claimed as a deduction by the settlor. See IRC § 170(f)(2). Generally, the trust must take the form of either an annuity trust or unitrust. See IRC § 664(d).

Annuity Trusts (CLATs, CRATs)

The “guaranteed annuity” method of payment of a charitable lead annuity trust (CLAT) grants the charity an irrevocable contractual right to receive a sum certain (either a fixed amount or a stated percentage of the fair market value of the trust assets), payable at least annually, either for a preset number of years or terms or for the life of an individual, who must be living at the date of the gift. No minimum or maximum annuity payments are required.

Income in excess of the amount needed to pay the guaranteed annuity may be retained by the trust, distributed currently to the charity or paid to the private beneficiary remainder person(s).

EXAMPLE: Agnes is an alumna of Pepperdine University. To make a charitable contribution to her alma mater, she decides to establish a charitable lead annuity trust (CLAT). She has $300,000 to donate. The remainder will go to her 33-year-old daughter, Anastasia or her issue. Using an IRS discount rate of 4.2%, with an annual payout of 10%, the annual payment to Pepperdine will be $30,000. Agnes’s charitable deduction will be $296,358.

In the case of a charitable remainder annuity trust (CRAT), the private income beneficiary must be entitled to receive annually a specified dollar amount (which is not less than 5 percent or more than 50 percent of the initial fair market value of all property placed in trust) for the life or lives of those beneficiaries or for a term of not more than 20 years. See IRC § 664(d)(1)(A). At the end of one of these periods, the remainder will go to the charity. See IRC § 664(d)(1)(C). Any gain or loss due to changes in value would inure to the remainder interest since the amount payable to the private beneficiary is fixed at the time the trust is established.

Unitrusts (CLUTs, CRUTs)

In contrast to the CLAT, the CLUT grants the charity an irrevocable contractual right to receive a payment, payable at least annually, for a preset number of years or a term certain. The payment is a fixed percentage of the “net fair market value” of the assets of the trust, determined annually.

EXAMPLE: Agnes is an alumna of Pepperdine University. To make a charitable contribution to her alma mater, she decides to establish a charitable lead unitrust (CLUT). She has $300,000 to donate. The remainder will go to her 33-year-old daughter, Anastasia or her issue. Using an IRS discount rate of 4.2%, with an annual payout of 10%, the annual payment to Pepperdine will be $30,000 (future payments will vary with the trust value). Agnes’s charitable deduction will be $288,486.

Because the amount to be paid by the charity varies yearly with a unitrust, to safeguard the charitable interest, a key requirement is the duration of the payment period. For a unitrust method of payment to qualify for a charitable deduction, the payout period must be ascertainable at the outset, whether for a specified period (actual) or for a measuring life or lives (actuarial). See Treas. Reg. § 25.2522(c)-3(c)(2)(vii).

With both methods of payment, if the actual amount of income that the trust assets earn should fall short of the required payment, the trustee is obligated to invade principal to make up the difference.

The present value of a unitrust is determined by subtracting:

1. The present value of the remainder interest, from
2. The fair market value of the transferred property at the date of the transfer.

See Treas. Reg. § 25.2522(c)-3(d)(2)(v).

In the case of a charitable remainder unitrust (CRUT), the private income beneficiary must receive an annual payment equal to a fixed percentage of the trust principal (not less than 5 percent or more than 50 percent of the net fair market value of the property), valued annually, for the life or lives of those beneficiaries or for a term of not more than 20 years. See IRC § 664(d)(2)(A). At the end of one of these periods, the remainder will go to the charity. See IRC § 664(d)(1)(C).

EXAMPLE: Agnes is an alumna of Pepperdine University. To make a charitable contribution to her alma mater, she decides to establish a charitable remainder unitrust (CRUT). She has $300,000 to donate. Using an IRS discount rate of 4.2%, a 20-year term and an annual payout of 10%, the annual payment to her 33-year-old daughter, Anastasia (or her issue) will be $30,000 (future payments will vary with the trust value). The remainder will go to Pepperdine in 20 years. Agnes’s charitable deduction will be $38,580.

Another restriction is that the value of such remainder interest in the contributed property must be at least 10% of the net fair market value of the property as of the date such property was contributed to the trust. See IRC § 664(d)(2)(D). In addition, the payment to the private beneficiary could be limited to the trust income if that amount is less than the fixed percentage. See IRC § 664(d)(3)(A).

EXAMPLE: Agnes is an alumna of Pepperdine University. To make a charitable contribution to her alma mater, she decides to establish a charitable remainder unitrust (CRUT). She has $300,000 to donate. Using an current IRS discount rate of 4.2% and an annual payout of 10%, the annual payment to her 33-year-old daughter, Anastasia (or her issue) will be $30,000 (future payments will vary with the trust value). Agnes’s charitable deduction will be $11,514. The trust, however, does not qualify as a CRT because its charitable remainder value is less than 10% of the initial principal.

The charitable and private beneficiaries would share alike in increases or decreases in the value of the trust corpus. Accordingly, the amount of the annual unitrust payment fluctuates according to the net fair market value of the trust assets.

Pooled income fund

A third method of using split interest gifts is a pooled-income fund. See IRC § 642(c); Rev. Proc. 88-53. Under this mechanism a trust or other fund is maintained by a charitable organization to which the settlor transfers money or property and in return receives a pro rata share of all income earned by the fund based on the amount that he or she contributed to the fund. The charity gets the remainder interest after the settlor has died. The settlor gets an estate tax (or gift tax) deduction for the transfer of a remainder interest in property to a pooled income fund. See IRC § 2055(e)(2).

EXAMPLE: Agnes, age 72, is an alumna of Pepperdine University. To make a charitable contribution to her alma mater, she decides to contribute $5,000 to Pepperdine’s pooled income fund. Using an annual payout rate of 6.22840164%, the annual payment she will receive is $311.42 (future incomes will vary with the fund earnings). Agnes’s charitable deduction will be $2,547.50.

The charitable institution invests the funds, along with other funds contributed by other settlors or donors under similar transfers, and pays out a proportionate share of the total income earned by the fund to each of the donors to the fund. The holder of the lead/income interest receives “participation units” that fluctuate in value according to the performance of the pooled income fund. As each life income interest terminates, the remainder interest is separated from the pooled fund and goes to the charity for its unrestricted use.

The essential elements of a pooled income fund include the following:

1. The settlor must irrevocably transfer the remainder interest in the money or property to the fund created by and for the exclusive benefit of a single public charitable organization;
2. The fund must be created by and for the exclusive benefit of a single public charitable organization;
3. The property transferred into the trust must generate taxable income;
4. The transferred property, which generates income, must be commingled with property from other donors; and
5. The settlor must retain an income interest for life or create a life income interest for the benefit of one or more beneficiaries at the time of the transfer.

If the fund fails to satisfy these requirements not only will the transfer not receive the expected federal wealth and income tax benefits, the irrevocable nature of the transfer means that the settlor will not be able to get his or her property back.