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What’s Wrong With This Gift?

Planned Giving Today

Originally Published in Planned Giving Today.


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Egbert Entrepreneur, age 58, responds to a solicitation in Charity’s newsletter which reads: “Save Big Taxes — Let Us Plan the Disposition of Your Retirement Benefits for You!” Egbert explains to Peter Grasping Oglethorpe, who is Charity’s PGO, that and acquaintance lent him a copy of the newsletter at a recent cocktail party. He says he thinks Charity probably must do some important work or other, and that he whole-heartedly shares the Charity’s mission of saving people from having to pay taxes.

Egbert says that he takes great pride in the fact that, so far as he can tell, his retirement plan is substantially more well-stuffed than any of his wealthy entrepreneurial friends. PGO expresses his admiration for this achievement and encourages Egbert to go on. Egbert says he thinks he remembers hearing his CFO say his retirement plan is called a “defined benefit” or “defined contribution” plan, or words to that effect. PGO furrows his brow in concentration for a moment, then pronounces Egbert’s retirement benefits to be ideally suited for Charity’s plans.

PGO advises Egbert that, while the retirement benefits will escape taxation at his death, for his own income tax planning he really should consider making a lifetime gift of the bulk of the benefits to Charity, preferably outright, but perhaps in a charitable remainder unitrust as an alternative. PGO also waxes enthusiastically about Charity’s new pooled income fund and encourages Egbert to make a large contribution to this fund, as well, again in the interests of minimizing income tax consequences.

Egbert says he vaguely remembers a friend saying that an attorney had recommended funding a testamentary charitable remainder unitrust with retirement benefits. Gently, but firmly, PGO corrects this miscommunication, and puts the lifetime gift back on track. Egbert’s suit against Charity is not filed for many years, long after PGO has switched career paths and become a celebrated financial planner.

There is a possible limitation on the antitrust exemption, but this would require specific state action within a period of three years. Presumably, state legislatures will not deem it necessary to take any further action and the antitrust issue will be successfully resolved for future gift annuities.

Philanthropy Protection Act of 1995

The Philanthropy Protection Act of 1995 is a rather more comprehensive statute. It deals specifically with securities regulation issues.

Securities laws are designed to protect consumers. A multitude of organizations and institutions in our society issue securities of many different types. These stocks, bonds, annuities, insurance products and other securities are regulated by federal and state statutes that are designed to protect the consumer.

The basic goals of thes laws include a full and fair representation of the value underlying the security, and an explanation of the individuals and entities conducting the business activities represented by the securities.

As a result of the actions of charities in commingling trust assets, there has been greater movement toward securities regulation of charitable trusts and charitable pooled investment funds. Commencing in the 1980s, some charities began to combine unitrust principal amounts into common investment funds. Unquestionably, the creation of hte larger funds diversified risk and enabled more professional management of the join fund. While the corpus of all charitable remainder unitrusts and annuity trusts is treated as a separate investment, it has been the practice of some charities to pool the investment amounts and then distribute the earnings in investments among the trusts. In this sense, the internal common funds are comparable to private mutual funds.

This practice certainly creates the kinds of risks that are specifically addressed by the securities regulation. The common funds represent underlying securities and it is entire fair and appropriate that there be full disclosure of the risks involved and management practice so that prospective donors understand the nature of the unitrust and annuity trust investments.

The purpose of the Philanthropy Protection Act provisions is to exempt the charitable common funds from the full requirements of the Investment Company Act of 1940, but to require a level of disclosure that is appropriate for these common funds. Section 2(a) of the Philanthropy Protection Act exempts the pooled income fund, a fund set aside as a reserve for charitable gift annuities, common remainder trust or lead trust funds, and other irrevocable charitable trust funds from the Section 3(c)(10) of the Investment Company Act of 1940. This means that the charitable funds are no longer “investment companies” for purposes of the act. However, Subsection(e) of the same statute requires that, in exchange for exception, the fun shall provide “to each donor to such fund, at the time of the donation or within 90 days after the enactment of this sub-section, whichever is later, written information describing the material terms of the operation of such funds.”

Effective Date

Since the bill was signed on December 8, 1995, the effective date for this provision is March 7,1996. While the apparent intent of the statute was to cover new gifts, the language seems to require some level of disclosure to all donors of covered funds. This could be interpreted to require a disclosure statement for all current donors where there are commingled gift annuity or trust funds.

What then are the requisite “material terms?” Is there a difference between the requirements for a gift annuity, a pooled income fund, a revocable trust, a charitable gift?

Here’s What’s Wrong With This Gift

  1. Excess Accumulations Excise Tax. PGO’s admiration for Egbert’s “well-stuffed” retirement plan ins probably misplaced. Egbert’s estate may well be subject to the special 15 percent excise tax on excess accumulations in qualified plans, under Internal Revenue code section 4980A. In brief summary, this excise tax could be imposed on Egbert’s estate if his plan includes more funds than would be necessary to purchase a theoretical life annuity of $150,000 per year for Egbert’s assumed life expectancy.
  2. Defined Benefit Plan vs. Defined Contribution Plan. Before making any recommendation as to the possible charitable disposition of Ebert’s retirement plan funds, PGO should at least determine whether Egbert’s plan is a “defined benefit plan,” or a “defined contribution plan,” two very different types of plans. In a “defined benefit plan,” the benefits terminate at the death of the employee (or may continue for the lifetime of a spouse); consequently, there are no benefits left to pass to charity. In a “defined contribution plan,” in contrast, the benefits typically continue until the plan account is exhausted; consequently, such plan benefits often survive the employee and spouse. Consequently, the “defined contribution plan” is a good candidate for charitable giving.
  3. Benefits are Subject to Estate Tax. Contrary to PGO’s assertion, Egbert’s plan benefits will not necessarily escape taxation at his death. If he is married and his wife is designated as beneficiary, then the unlimited marital deduction should shelter the benefits from taxation as his death, if she survives him. If he is unmarried, or if his wife predeceases him, or again if the account is not exhausted before both deaths, then the benefits will typically be subject to estate tax, at rates ranging from 37 percent to 55 percent. The benefits also constitute and item of “IRD” (“income in respect of a decedent”), which means ordinary income recognition to the estate or to the ultimate beneficiaries. Retirement plan benefits and other IRD items make excellent charitable gifts for this reason.
  4. Lifetime Charitable Gifts of Plan Benefits Trigger Income Tax. It will be unwise for Egbert to follow PGO’s suggestion that Egbert make current gifts of the plan funds to Charity or to a lifetime CRT. Assuming the gift is even allowable under the plan, any such gift will be treated for income tax purposes as a taxable withdrawal by Egbert, triggering ordinary income to him. (Actually, there is a delightful planning technique involving current charitable gifts to help reduce the excess accumulations tax, but, alas, this is beyond the scope of this piece.)
  5. Gifts to PIFs Cause Huge Problems. It will be even unwiser for Egbert to make a current gift of plan funds to Charity’s pooled income fund. Unlike a CRT, a pooled income fund is not tax-exempt; consequently lifetime or testamentary gifts of plan funds can have most unpleasant results. For example, the other pooled income fund donors may not appreciate learning that they must pay income tax on their share of the “phantom” income triggered by the gift, which probably constitutes “corpus” for purposes of the pooled income fund, and hence is not distributable to them.
  6. Egbert’s Friend Was Right. The friend that told Egbert he might fund a testamentary CRUT with retirement benefits was on track. In addition to sheltering the benefits from estate tax and protecting against “IRD” income, the gift to the CRUT may help Egbert’s children as CRUT beneficiaries to spread out their income tax payments in a much more favorable manner than if they recieved distributions directly from the plan. If the CRUT were not used, then, depending on the circumstances and the elections made by the employee, the children might have to receive all the plan distributions (and pay the income tax associated with the distributions) in as little as five years, or in some cases, a single year, following Egbert’s death.
  7. Ethics. Perhaps PGO and Charity should reconsider their somewhat aggressive gift-generating practices.

IRS Circular 230 Disclosure: To the extent this message contains tax advice, the U.S. Treasury Department requires me to inform you that any such advice, whether in the body of the message or in any attachment, is not intended or written by my firm to be used, and cannot be used by any taxpayer, for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code. Advice from my firm relating to tax matters may not be used in promoting, marketing or recommending any entity, investment plan or arrangement to any taxpayer.

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