This handout is designed to illustrate the use of Family Charitable Remainder Trusts for income tax and estate tax planning and to answer some questions you may have with regard to its use.

1.0 WHAT IS AN FCRT?

The FCRT is a combination of planning techniques designed to provide income tax, estate tax, and philanthropic benefits. Generally, the FCRT is a combination of a charitable remainder trust (“CRT”), a defective grantor trust (“DGT”), and family limited partnership or limited liability company (“FLP”) in a unique way.

1.1 Charitable Remainder Trust. A CRT is a form of irrevocable trust in which you transfer cash or property and retain the right to receive payments for a selected term and where any remaining amount of the trust passes to a charity you select at the end of the selected term. Because the charity is the ultimate remainderman, the IRS treats the trust as income tax-exempt.

1.2 Defective Grantor Trust. The DGT is a form of Irrevocable Trust. The trust is structured so that the grantor of the trust retains powers over the trust causing it to be “defective” for income tax purposes (i.e., any income earned by the trust is taxable to the grantor rather than to the trust or the trust beneficiaries). However, the trust is structured so that transfers to this trust are completed transfers for estate and gift tax purposes.

1.3 Family Limited Partnership. The FLP is a family entity created and controlled by you to which property, such as marketable securities, real estate, or other non-personal assets, can be contributed. All income of the FLP is passed through the FLP to the FLP partners and no entity level tax is imposed. The FLP is structured to allow the transfer of up to 99% of the value of the entity without relinquishment of control through the use of voting and non-voting interests. Additionally, the use of the FLP allows you to ensure the underlying assets are not subject to transfer, either voluntarily outside the family unit or involuntarily to creditors. To the extent the underlying assets might create liability for the owner, a limited liability company could instead be used to shield the owners from such potential liability.

2.0 HOW DOES THE FCRT WORK?

2.1 In general, the FCRT allows a taxpayer to defer the recognition of income tax on diversification of an appreciated asset and provides you with an immediate income tax deduction. The FCRT also allows you to pass significant wealth to your heirs (including grandchildren) with minimal gift tax cost. Specifically, the FCRT allows you to conduct a “sale to a DGT” with non-income producing property and/or marketable securities without immediate recognition of gain on sale of the property. Lastly, the FCRT provides a substantial charitable benefit to your favorite charity (including possibly your own private foundation).

2.2 However, to fully understand how an FCRT works, you must first understand how a CRT and sale to a DGT work.

3.0 HOW IS A DGT DIFFERENT FROM OTHER TRUSTS?

3.1 Rather than being taxed to the trust or the trust’s beneficiaries, all income from the DGT will be attributed to the grantor, who is legally obligated to pay the tax attributable to the income.

3.2 The DGT is structured so that the entire value of the trust will escape estate tax inclusion at the grantor’s death.

3.3 The grantor and DGT are treated as a single entity for income tax purposes, and thus no income tax will have to be paid on the sale of property (even if appreciated) to a DGT as long as the grantor is living.

3.4 The grantor retains the power to reacquire the trust property for cash or other assets. This may allow the grantor to obtain the stepped-up basis at death on the assets transferred to the trust by reacquiring those assets before death.

4.0 WHAT BENEFITS DOES A CRT PROVIDE?

4.1 Benefits to Charity. Because the charity or charities you select is named as remainder beneficiary of the CRT, the charity obviously benefits from creation of the trust. However, even if you are not charitably motivated, the tax-exempt nature of the trust may still make the CRT an excellent income tax saving vehicle to you.

4.2 Benefits to You.

(a) Capital Gains Tax Prevention. If highly appreciated assets are transferred to the CRT, the tax-exempt nature of the trust allows it to sell the assets and defer, and potentially avoid, any capital gains tax that would otherwise be imposed if you sold the assets yourself. In this situation, a CRT effectively allows you to convert the appreciated assets into an income stream without imposition of capital gains taxes on the sale.

(b) Charitable Deduction. Upon creation of the trust, you will get a deduction for the value of the interest passing to charity even though the charity will receive no interest for several years. The deduction varies depending upon the terms of the CRT, but typically is 10% of the current property value transferred to the CRT.

(c) Imposition of DGT. The imposition of the DGT does not impact the overall benefit of the CRT to you since the FLP is a pass through entity and the DGT ignored for income tax purposes.

5.0 HOW CAN I USE AN FCRT FOR INCOME TAX, ESTATE TAX, AND PHILANTHROPIC BENEFITS?

5.1 Creation of FLP.

(a) You would first create an FLP and contribute appreciated property such as marketable securities or real estate.

(b) You would retain voting and nonvoting interests in the entity and the entity would limit the transferability of the interests outside the family unit.

(c) The entity would need a second partner to be valid and such person could be a spouse, child, or other entity.

5.2 Creation of CRT.

(a) The FLP itself would create the CRT and contribute most or all of the appreciated property directly to CRT in exchange for 20 year payout of approximately 11.5%.

(b) If publicly traded securities were contributed to the FLP, the FLP could name a private foundation or public charity as remainder beneficiary of the CRT and obtain a full fair market value federal income tax deduction.

(c) The charitable deduction would be approximately 10% of the undiscounted value of the appreciated property and would flow through the FLP to you according to your basis in the property.

5.3 Creation and Funding of DGT.

(a) You would then create a DGT personally and gift 5-10% of the limited partnership interests in the FLP to such trust.

(b) A 10% discount would automatically apply to the underlying property due to the existence of the charitable beneficiary’s interest in the CRT. Additionally, the limited partnership interest in the FLP presumably would garner a minority and marketability discount between 25-40%.

(c) This gift would utilize a portion of your lifetime unified credit and no gift tax would be incurred to the extent you had sufficient unified credit available.

(d) To the extent grandchildren were intended beneficiaries of the DGT, you would also need to allocate GST exemption to the gift.

5.4 Sale to DGT.

(a) You would then sell some or all of the remaining limited partnership interests in the FLP to the DGT in exchange for a promissory note.

(b) The note would bear interest at the minimum amount required under IRC 7520 and be payable annually.

(c) To the extent the gift to the DGT was less than 10% of the overall transfer, we would suggest that a portion of the note be guaranteed by your children or by another entity.

(d) In order to prevent the sale and gift from being treated as a single transaction, it is best to provide some time period between the sale and the gift of property to the DGT and the longer the time period the better.

5.5 Sale of Appreciated Property in CRT.

(a) The trustee of the CRT could then sell some or all of the appreciated property without immediate income tax.

(b) However, there is no requirement that the property be sold immediately and if the value of the property is depressed, the trustee can hold the property until the time is appropriate to sell.

(c) In either case, to the extent the underlying property is not income producing, it is contemplated that at least enough of the contributed property will be sold to satisfy the annuity payment at the end of the first taxable year of the CRT.

5.6 Annual CRT Distribution.

(a) On the anniversary of the creation of the CRT, the CRT would make its payout to the FLP. Such amounts could then be distributed to the partners of the FLP (which presumably could allow up to 99% to flow to the DGT).

(b) Because the DGT is a grantor trust, you would pay all the income tax associated with the CRT payment.

5.7 Annual DGT Note Payments.

(a) On the anniversary of the sale to the DGT, the DGT would make interest and/or principal payments on the promissory note owed to you.

(b) You could use the payments on the promissory note to cover any income tax flowing to you from the DGT.

(c) As a result, while the notes are outstanding, you could receive as much as 100% of the distributions from the CRT, the same as if you had not utilized the DGT.

5.8 Repayment of Outstanding Promissory Note.

(a) While only income would be required to be distributed, the 11.5% payout presumably would be enough to make substantial principal payments on the note.

(b) Depending upon the growth of the property inside the CRT and thus the amount of each payout, the promissory note could be repaid in 7-13 years.

(c) As a result, all remaining payments from the CRT effectively would pass to the DGT without gift tax.

(d) You could then decide to continue to pay the income tax of the DGT (a good estate planning technique) or terminate the grantor trust feature of the DGT.

(e) In either case, a substantial benefit presumably should remain in the DGT after the note has been fully repaid.

5.9 Distribution to Heirs.

(a) Once the notes have been repaid, the balance of the DGT and the value of the FLP (including all remaining CRT payments payable to the FLP) could be held for or distributed to your heirs. The beneficiary’s could include your grandchildren to the extent you allocated your GST exemption to the original gift.

(b) Additionally, to the extent proper security exists for the note, the assets of the DGT might be available for distribution to your heirs during the term of the note as well as after full repayment.

5.10 Distribution to Charity.

(a) At the end of the twenty-year term of the CRT, the balance of the CRT would pass to your designated charity or charities.

(b) You have the right to change the designated charitable beneficiary anytime during the 20 year term and can designate your private foundation (as discussed below).

(c) You also can retain the ability to irrevocably designate a specific charity as a remainder beneficiary to part of all of the CRT.

6.0 WHAT IF I NO LONGER WANT TO PAY THE DGT’S INCOME TAX?

The DGT will be structured so that the grantor retains the ability to cancel the “grantor trust provisions” and cause the income tax to be apportioned to the FLP partners according to ownership (i.e., 99% to DGT) thereafter. While the grantor’s right to cancel can be exercised during the term of the note or anytime thereafter, once canceled, the grantor cannot re-establish the grantor trust provision and begin recognizing the income tax liability again.

7.0 HOW IS THE FCRT DIFFERENT FROM A REGULAR SALE TO A DGT?

With a regular sale to a DGT, the best property to use for the technique is income producing property since cash flow must be generated to cover the interest and principal payments required on the promissory note. As such, marketable securities and other non-income producing property are not good candidates. While the contributed property could be sold to generate the liquidity to make the necessary note payments, such sales would generate taxable income to the grantor. Therefore, the FCRT provides a mechanism to convert such non-income producing property into income producing property without immediate recognition of income tax.

8.0 CAN THE REMAINDER BENEFICIARY BE A PRIVATE FOUNDATION?

8.1 Rather than passing the CRT assets outright to a public charity upon the end of the 20 year term, you can instead name a private foundation as the remainder beneficiary. The private foundation can be then-existing or can be created upon termination of the initial income term (i.e., upon your death according to your wishes). A private foundation effectively allows you (or your children) to continue to control the trust property even after your death.

8.2 The main disadvantage to naming a private foundation as remainder beneficiary is that your charitable deduction may be limited depending on the asset you transfer to the CRT. However, if the underlying property is appreciated publicly traded securities, your charitable deduction for federal income tax purposes should not be limited (although it may still be limited for state income tax purposes). If your deduction will be limited, you may want to name a community foundation as remainder beneficiary since the deduction rules are more generous, but still allow you to retain some control over the trust assets. Alternatively, you always have the option of simply naming a public charity.

9.0 WHAT ARE THE POSSIBLE DISADVANTAGES TO USING AN FCRT?

9.1 The IRS could argue that either the payment of the income tax liability of the trust is a “gift” by the grantor or that the sale to the DGT will cause gain to be recognized by the grantor. However, we believe it is more likely than not that the IRS would lose such arguments and the IRS has basically conceded the invalidity of these arguments in recent private letter rulings.

9.2 The IRS could argue that sale is actually a “gift” under the retained interest section of the Code or that death during the term should cause estate tax inclusion. However, as long as the sale is structured as a transfer for full fair market value, is not dependent on the income from the property, and appropriate funds are “seeded” into the DGT prior to the sale, this argument can be avoided. The IRS recently conceded this point in private rulings as well.

9.3 An unexpected death prior to the note being paid in full may result in gain being recognized for income tax purposes. The IRS may argue that under the installment method, the balance of the payments due under the note must be recognized as income upon the death of the grantor. In this case, the income tax basis of the property held in the DGT would presumably be increased to the extent of income tax paid by the grantor. However, the law in this area is unclear and we believe that there is a good argument that the grantor’s death produces no income tax consequences. This tax cost could be offset through the purchase of term life insurance.

9.4 If the IRS determines that the minority and marketability discount taken on the non-voting interests transferred to the DGT, or the value of underlying property, were incorrectly calculated, the IRS could argue that a portion or all of the DGT property would be included in your estate and/or that an additional gift (of up to the amount of the transfer) was made when the original transfer occurred. For this reason, it is imperative to obtain an accurate appraisal from a qualified professional appraiser of the underlying property and the non-voting interests transferred to the DGT. This is especially true when the FLP is funded solely with marketable securities. To further prevent this problem, the trust documents should be carefully drafted with a “revaluation” clause whereby the amount of the transfer could be later amended to more accurately reflect the value of the property. However, the IRS has not ruled specifically on the validity of such a provision. For this reason, as stated, it is imperative to obtain accurate qualified appraisals of the property at the time of the original transfer.

9.5 With respect to the CRT, one detriment is that you have limited access to the trust principal, even though the amount of the trust principal will likely be greater with the CRT. This may be a bigger problem to the extent the grantor dies while the promissory notes are outstanding. In that case, the notes will be included in the grantor’s estate and other assets of the grantor will be needed to satisfy any estate tax created (and possibly any income tax created) by the existence of such notes. Again, this risk can be offset through the purchase of term life insurance

9.6 The IRS does not allow you to avoid gain on the sale of property contributed to the CRT if the sale was pre-arranged prior to contribution. Generally, the IRS looks to whether the CRT is obligated to sell the assets as part of the pre-arranged sale in determining whether to attribute the gain to the donor or the CRT. While some negotiation of an upcoming sale will not likely cause attribution of the gain to you, it is imperative that no formal negotiations be finalized and you should transfer the property to the CRT as early as possible.

9.7 Because the CRT is a tax-exempt entity, there are some restrictions on the types of investments in which the CRT can invest trust assets. Generally, the CRT is prevented from investing in operating businesses and businesses in which you hold a controlling interest. However, there are no restrictions on the investment options for the assets distributed to the FLP, whether kept at the FLP or distributed to the DGT.

9.8 There is a possibility that the IRS might attempt to invalidate the CRT by providing that CRT had multiple beneficiaries. This argument was made in a recent private ruling dealing with the contribution of property to a 20 year CRT by an S Corporation. However, in that case, the CRT provided a distribution to the S Corp for 19 years and a distribution to the S Corp shareholders in year 20. In this case, the FLP will be the sole non-charitable beneficiary for the entire term. Additionally, several other IRS rulings have provided that an entity such as an FLP is a permissible grantor of a CRT. The mere fact that the ownership of the FLP changes after the original contribution should have no bearing on the analysis.

Clay R. Stevens © 2010